Journal
INTERNATIONAL JOURNAL OF FORECASTING
Volume 30, Issue 3, Pages 717-728Publisher
ELSEVIER
DOI: 10.1016/j.ijforecast.2013.10.003
Keywords
Capital requirements; Leverage; Systemic risk
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How much capital and liquidity does a bank need to support its risk taking activities? During the recent (and still ongoing) financial crisis, answers to this question using standard approaches, e.g., regulatory capital ratios, were no longer credible, and thus broad-based supervisory stress testing became the new tool. Bank balance sheets are notoriously opaque and susceptible to asset substitution (easy swapping of high risk for low risk assets), so stress tests, tailored to the situation at hand, can provide clarity by openly disclosing details of the results and approaches taken, allowing trust to be regained. With that trust re-established, the cost-benefit of stress testing disclosures may tip away from bank-specific towards more aggregated information. This paper lays out a framework for the stress testing of banks: why it is useful and why it has become such a popular tool for the regulatory community in the course of the recent financial crisis; how stress testing is done (design and execution); and finally, with stress testing results in hand, how one should handle their disclosure, and whether it should be different in crisis vs. normal times. (C) 2013 International Institute of Forecasters. Published by Elsevier B.V. All rights reserved.
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